(PUB) Investing 2015

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Puerto Rico’s Back in the Hot Seat Income Strategist | Elizabeth Foos

Rico’s bond obligations are largely owned by indi- vidual investors and various hedge funds.

Noticeably absent from the list of large investors in the island’s debt are some of the bigger players in the municipal space. The fixed-income teams at Fidelity, T. Rowe Price, and Vanguard have largely steered clear of investing in Puerto Rico. None of the 23 Fidelity municipal funds had assets invested in the commonwealth’s bonds as per the most recent portfolio data provided to Morningstar. Several T. Rowe Price and Vanguard municipal funds do have some minuscule exposure to Puerto Rico. OppenheimerFunds and Franklin Templeton Invest- ments are two of the largest holders of the common- wealth’s debt with some of the largest concen- trations in single-state funds. The Oppenheimer funds hold some of the heaviest weightings to the commonwealth’s debt. Based on the latest portfolio data provided to Morningstar, 19 of the 20 Oppen- heimer Rochester funds had some exposure to Puerto Rico, and 17 had weightings in the double digits ranging from just over 10% of assets to nearly 50% of assets. Allocations in the Franklin funds, while still meaningful, tended to be much smaller. Of the 32 funds in the Franklin municipal-fund complex, 26 funds listed some exposure to Puerto Rico’s bonds in their most recent portfolios provided to Morningstar; 12 funds had exposures of between roughly 4% and 7% of assets. The exception here is the closed Franklin Double Tax-Free Income FPRTX , which holds over 50% of assets in Puerto Rican debt as of June 30 . In contrast, the largest national muni funds had small weightings to Puerto Rican debt, usually less than 2% of assets. Currently, none of the above-mentioned Oppenheimer- Funds funds or Franklin funds with more than a 5% allocation to Puerto Rico are included in the Morningstar 500 list nor do they carry a Morningstar Analyst Rating. The two Franklin funds that are featured on the list in July, Franklin Federal Tax- Free Income FKTIX and Franklin High Yield Tax-Free Income FRHIX , currently list weights of less than 4% to Puerto Rico’s bonds. K Contact Elizabeth Foos at elizabeth.foos@morningstar.com

Gov. Alejandro Garcia Padilla of the commonwealth of Puerto Rico warned on June 29 that the U.S. terri- tory couldn’t pay its $72 billion of debt. Padilla has directed a working group to negotiate with creditors and develop a debt-restructuring plan that would defer debt payments by “a number of years” by the end of August. The commonwealth’s municipal bonds have histori- cally been favored by a meaningful number of mutual funds because they pay higher yields and have “triple tax-exempt” benefits. That status means the interest earned on Puerto Rico’s bonds is not only shielded from federal income taxes but also state and local income taxes, because of its status as a U.S. territory. That fact alone had been a powerful moti- vator for some investors to overlook the credit risks presented by debt of the commonwealth. It had also made these bonds attractive to some municipal- bond fund managers who run funds invested in single- state markets, because by prospectus many single- state muni funds can invest in Puerto Rico’s bonds. In addition, the SEC enabled single-state muni funds to buy Puerto Rican debt in large quantities by waiving the name rule requirement that says funds must invest at least 80% of assets in the asset class implied in the fund name. If the SEC hadn’t done that, then a New York muni fund would have been limited to less than 20% of assets in Puerto Rico. More than 20% of U.S. open-end bond mutual funds—the vast majority of which are municipal and dedicated high-yield municipal funds—collectively own more than $11 . 4 billion of the island’s debt, or just over 15% of its outstanding issuance. More specifically, roughly 50% of U.S. open-end municipal- bond funds hold some exposure to debt of the commonwealth, ranging from less than 1% of assets to more than 50% of assets. The balance of Puerto